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Fertiliser Prices The Key Risk For Incitec Pivot

Australia | May 11 2017

Incitec Pivot produced an upbeat outlook after its first half result but brokers are not that convinced. Spot pricing for many of the company's fertiliser exposures is rapidly deteriorating.

-Significant improvement in free cash flow requires consideration of capital options
-Fertiliser-linked commodity prices likely to be under increased scrutiny
-Options for Gibson Island being considered


By Eva Brocklehurst

Incitec Pivot ((IPL)) produced an upbeat outlook after its first half result but brokers are not that convinced. Spot pricing for many of the company's fertiliser exposures is rapidly deteriorating and adds considerable risk to the second half.

Morgan Stanley observes this is particularly the case for urea manufacturing, which appears at risk of being loss-making through the second half. Also, the explosives industry may experience renewed pressure from significantly weaker bulk commodity prices in the second half. The broker believes other features such as a sequential lift in net interest costs, higher tax rates, and the negative impact of Cyclone Debbie will weigh through the remainder of FY17.

Deutsche Bank agrees the outlook commentary is more positive than normal and needs to be balanced against the recent decline in fertiliser prices and an upcoming change in the CEO. That said, the broker cites a positive outlook for the US explosives business with higher-margin volumes up 5% over the half-year. Meanwhile, coal production is recovering and the company has won the Peabody contract in the Illinois Basin. Australian fertiliser demand is also up 43%, underpinned by improved agricultural market conditions and water storage levels.

Shareholder Returns?

Deutsche Bank believes the WALA ammonia plant, Louisiana, will provide a step-change in earnings over the next two years and the company will seek to return capital to shareholders upon the attainment of reliable production. Credit Suisse is less confident in the outlook. Beyond obvious movements in fertiliser prices, the company appears to be in a holding pattern in the absence of a long-term CEO and the broker finds little to interpret from current management commentary in relation to shareholder return intentions.

The broker acknowledges free cash flow will improve significantly from the second half, in the absence of capital expenditure growth, and this requires a consideration of the options. Furthermore, investment opportunities within the existing scope of businesses appear too low, or only marginally above the cost of capital. Balancing growth expectations with the market reality is probably the key to shareholder returns, in the broker's opinion. Credit Suisse downgrades to Underperform from Neutral.


Citi is in the more bearish camp. The broker acknowledges the company has achieved its transformation strategy, with the last of three assets (WALA) forecast to ramp up to its targeted 800,000 tpa capacity by the end of FY17. Without a further growth strategy, and on the eve of management changes, the broker suspects the company will now be subject to even more scrutiny around fertiliser and energy prices. This is reflected in the broker's revised estimates and the recommendation is downgraded to Neutral from Buy.

A -67% fall in fertiliser operating earnings (EBIT) may have helped management's case that fertiliser earnings represented just 6% of group first half operating earnings but Citi is reminded that industrial chemical earnings from the newly commissioned WALA plant have fertiliser-linked pricing exposure. Like steel stocks, earnings can be shaped by the spread between traded ammonia prices and natural gas feedstock prices.

The WALA FY17 plant utilisation rate implies lower second half estimates compared with first half, which Citi calculates reflects a pit stop to remedy some outstanding commissioning issues. Earnings estimates improve sequentially in the second half on expectations of improved ammonia manufacturing spreads but this highlights, in the broker's opinion, the attention that commodity prices will again command.

Manufacturing efficiency and the end of a multi-year capital works program signals the start of a period of reduced gearing and the capacity for capital returns. The broker expects that investors will, nonetheless, increasingly look for greater clarity around growth strategies and the deployment of cash for future opportunities.

UBS believes the company has illustrated an ability to deliver cost controls in the face of challenging commodity markets and, in the absence of a step-up in prices, that the significant uplift in free cash flow and rapid de-gearing is already reflected in valuation. The broker's estimates imply 20% growth in operating earnings into FY18 underpinned by the full run rate of the new ammonia plant.

In the near term, Macquarie expects US ammonia prices to follow urea prices lower, although weaker Australian dollar may be a partial buffer. The broker notes the stock provides good exposure to a positive US outlook, which accounts for 45% of FY18 estimated earnings via Dyno Americas and the WALA. The US theme should continue to strengthen over the next 12 months as quarry and construction and coal activity recovers pace.

Macquarie finds the observation that Gibson Island may have a future an interesting development, as the company continues to look at the options for the urea plant. Incitec Pivot is participating in a Queensland government tender process for new gas development to be used for domestic purposes. As part of this, the government is looking to develop new sources of gas which provide some potential for a viable gas source for Gibson Island although, the broker cautions, it is early days.

There are three Buy ratings on FNArena's database, three Hold and two Sell. The consensus target is $3.80, suggesting 3.1% upside to the last share price. Targets range from $2.53 (Morgan Stanley) to $4.35 (Deutsche Bank).

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